​​​​​​Is 'Smart Beta' the New Active Investing?

20 April 2016 ​

Globally the debate has long moved on from active versus passive to how these can be combined to assist an investor with optimally achieving their overall investment objectives.

We believe that both active and passive funds can blend well together in a diversified portfolio, and that much of the perceived disparity between the two is due to the few remaining myths that still surround active versus passive.

The new challenge today is how to blend active and passive building blocks together to build more diversified, risk-smart portfolios. Understanding the risk factors in your portfolio will lead to better insights and more informed portfolio construction decisions, says Jason Liddle, CIO of Satrix.

Before we begin, let us first distinguish between ‘beta’ and ‘alpha’. Simply put, (market) beta is the sensitivity that a portfolio has to the market. Previously, any outperformance of the market was termed alpha.

The industry has since sharpened their pencils on this phenomenon called ‘alpha’ and, what they have found says Liddle, is that it consists of common risk characteristics. In general, an active investment manager’s process would systematically gravitate or produce portfolios with a particular risk character. This is due to their philosophy and how they filter, analyse and construct their portfolios. The passive industry is able to extract this risk characteristic (value, momentum, quality, etc) for retirement funds and other institutional investors. As a result, the previous concept of alpha has slowly faded over the last decade.

Over the next few years, ongoing passive product innovation is likely to reign with the retirement fund member being the ultimate beneficiary.

Smart beta (also called factor investing) is in full bloom

Smart beta attempts to capture those common risk characteristics (factors) such as value, quality or momentum that seek to provide investors with a compensating return (premium) over the market for exposure to that risk. It is important that in harvesting these factors, they are implemented against an index and no human liberties are afforded when these attributes are harvested in the capital market.

Multi-asset class passive balanced funds provide further options if an institutional investor is looking for balanced exposure to all asset classes necessary for diversification. These products showcase the strong influence of strategic asset allocation. Strategic asset allocation (measured static exposure to all headline asset classes necessary for diversification) remains a significant driver of a balanced fund’s return. Further to this, an understanding of the risk premia that characterise each asset classes is important. For example, practitioners are changing the conversation from talking about bonds to the components that make up its premia: duration, credit etc….

You can invest in a multi-asset class index fund, such as a Balanced Index Fund, which offers passive exposure to all asset classes (that are highly representative and competitive), including bonds and equities (local and international) and property, on a fixed strategic asset allocation basis.

Smarter, diversified portfolio construction decisions

For retirement fund trustees and consultants, smart beta is a powerful concept if you understand the different risk factors already operating within active members’ investment portfolios.

Within our local industry, most active managers tend to exhibit the value bias in varying degrees. Combining these managers then leads to a portfolio that has a compounded value bias. When the value style struggles (as was the case prior to Jan 2016), the portfolio is impacted directly with no mitigating influence. There is a way to offset this risk, leading to improved diversification. Momentum and value index products have shown to be inverse in character (when momentum is performing, value tends to struggle, and vice versa). Juxtaposed with the value style, a momentum style exposes you to price and earnings momentum factors – attributes you will rarely find in a domestic, actively managed fund.

Smart beta funds therefore make it possible to deviate meaningfully and systematically from the All Share or Top 40 Index, diversifying across styles. One can choose the styles (risk characters) that you want and offset the ones to which less exposure is desired.

No performance compromise

We believe that markets are naturally inefficient. Behavioural finance experts say that humans are prone to emotions such as fear and greed, which leads to inefficiencies in the market. Smart beta can effectively take advantage of those inefficiencies.

It is a big misconception that because markets are inefficient, we need an active manager alone to capitalise on the opportunities presented. This is where the evolution of smart beta plays its critical role. No longer does an index tracker just track a market cap weighted index (providing exposure to pure market beta), but any market or risk factor can also be tracked to realise a multitude of objectives. In that sense, choosing a particular passive strategy to achieve inflation-beating returns can very much be an active decision.

It is important to understand that our capital market is a closed system. There will always be winners and losers. Further to this, market cycles work for and against us. Within this system there will always be winners and losers against the broad market. Active and passive can work together to help clients reach their overall investment objective, by mitigating the harmful cycles that work against them and ‘capitalising’ on those cycles that work for them, while also beating the broad market.

How skill is measured amongst active managers is important. We need to be careful about how we define it. True manager skill is rare. In the vast spectrum of products and investment managers out there, cautions Liddle, be careful about how you define and quantify skill. And rather be curious about passive products which can assist you in reaching your investment objectives. Maintaining exposure to the broad market or a factor (value, momentum or quality) is one example of managing risk when one is not convinced of the extent of skill out there while trying to adhere to your overall investment strategy.

What is driving total returns in active management?

If you consider that the market and other systematic (smart beta) factors can account for as much as 85% of market returns (source: Li & Qu; Financial Product Differentiation over the State Space in the Mutual Fund Industry, 2010), be aware that you can get exposure to this through passive vehicles at a much lower fee. The good news is that you can put portfolios together more cleverly without compromising performance. Members of course will be the ultimate beneficiary of this cost benefit in a retirement fund.

Don’t buy passive products just because they are cheap

Lower fees are undoubtedly the more attractive feature associated with passive. While these products present cheaper alternatives, cost shouldn’t be your overarching or focal reason. It is more important to ask to what extent this product is adding value to the overall investment strategy of your members’ retirement portfolios. Lower costs are merely a supporting reason.

Providing diverse returns for portfolio construction

It is important to point out how much more predictably and reliably smart beta building blocks perform relative to one another. Each style drives the market at one time or another, and is equally out of favour at other times. For example, momentum outperforms during boom times but underperforms in weak economic times. One would also expect more defensive strategies, such as low volatility and value, to do better in these times – and they do.

Understanding the source and nature of all the risks a fund is exposed to provides clearer insight into the extent and nature of the risk premium (compensating return) on offer. The marriage between this and sound risk management practice is pivotal to reaching one’s investment objectives.

To be truly diversified, one needs to combine an optimal blend of both active and passive, which will also enable better portfolio construction. With smart beta, factors (risk characteristics) perform more predictably and reliably over time.

Smart beta (or factor investing, as it is commonly known) offers a way to focus on risks that are rewarded systematically. It is a strategy that attempts to provide investors with systematic outperformance and is designed to be more cost-effective than pure active management.

Conclusion

Smart beta products are a disruptive but welcome financial innovation with the potential to significantly shape the business of traditional active management. They have redefined what active management has labelled as ‘alpha’ via simple, transparent, rules-based portfolios delivered at lower fees. They are very quickly redefining the ‘new active’. We believe that both active and passive players have an important role to play in our capital market in so far as liquidity and price discovery are concerned. Both disciplines can be combined in investment portfolios to help trustees reach their investment objectives.

Relative to active managers, passive vehicles offer a relative fee advantage. While past performance is no guarantee of future performance, we believe that the lower costs associated with a blend of active and passive funds do not compromise performance. For trustees, using a passive and smart beta fund as your core low-cost strategy alongside an unconstrained active management strategy for some true performance alpha is an important debate for those who are open to both approaches.

Download our presentation at the BATSETA Seminar held on 13 April 2016.